Harry Domash's Winning Investing


Assessing Management Quality

Management quality is one of the most important factors you need to consider when evaluating a company’s outlook, and hence, whether you’ll make money owning the stock.

How do you do that? We can’t call a firm’s top executives and tell them that we want to hang out with them for a few days while we evaluate whether or not they’re up to the job. But we don’t have to.

Non-Recurring Red Flags
Many market pros consider clean and straightforward accounting a hallmark of good management. For them, repeated nonrecurring charges are “red flags” signaling questionable accounting practices.

There’s nothing wrong with classifying expenses as nonrecurring when used appropriately, for instance, to exclude the effects of one-time events such as acquisitions, income tax refunds, or legal expenses.

But when companies report quarterly results, they often emphasize earnings from continuing operations. When calculating that number, they don’t subtract non-recurring charges from reported earnings. The problem comes in when company execs inappropriately and repeatedly classify expenses as non-recurring to boost reported earnings from continuing operations.

Unfortunately, many market reporters and stock analysts don’t question managements’ definition of non-recurring expenses. 

Easy to Check
It’s easy to spot nonrecurring charges because they are usually listed on separate lines on each company’s income statement. But the raw numbers don’t mean much by themselves. What’s significant for a micro-cap wouldn’t move the needle for a large company. So, it’s best to express the non-recurring expenses as a percentage of total sales, which is also shown on the income statement.

Do that by dividing the nonrecurring expenses by revenues (sales) and computing the result as a percentage. For instance, the ratio would be 10 percent if a company recorded revenues of $1,000 and listed $100 in nonrecurring charges (100/1000).

Getting the Info
You can find the needed information on many financial sites. I’ll use Yahoo Finance to demonstrate the process.

From the Yahoo Finance homepage (finance.yahoo.com), enter the company name or ticker symbol, and then select Income Statement listed under Financials. On the Income Statement, be sure to select Annual Data (not the quarterly data default).

For example, start with medial device maker Boston Scientific (BSX). Yahoo displays income statements for the last three fiscal years, in this case, ending in December 2007, 2008 and 2009. I calculated the percentage of non-recurring vs. revenues for those years as 14%, 34%, and 28%, respectively.

For comparison, look up the annual income statements for construction equipment maker Caterpillar (CAT). You won’t need your calculator for this one. Caterpillar did not record any non-recurring charges in each of its last three fiscal years.

You’d find the same results for Microsoft’s last three fiscal years (June 2008, 2009 and 2010), Cisco Systems did record non-recurring charges in its fiscal years ending in July 2007, 2008, and 2009, but in each year, the charges amounted to less than 1% of revenues.

Look for Patterns
Judging management quality is a subjective exercise. Most firms will from time to time incur costs that are truly nonrecurring. The trick is to differentiate those from the firms that persistently come up with nonrecurring expenses to boost reported earnings from continuing operations.

Looking for patterns is more significant than any single year’s number. You can do that by simply eyeballing the results or averaging the past three-year’s ratios. A single year above 15%, or three -year average ratios above 6% are red flags signaling the need for further research on your part.

Consider this strategy of analyzing non-recurring charges as another tool for your stock analysis toolbox. Clean accounting doesn’t guarantee that a company’s stock is headed higher.

published 9/26/10

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